With the slowdown in China’s economic growth claiming headline casualties from sellers of luxury goods to shipping companies, a new report says the debt problems of a less visible victim – the Chinese steel trader – could impact China’s banks.

According to the report, produced by Bernstein Research, the problem began – as do so many financial bubbles — with plentiful cash. As in other corners of the commodity world, Chinese steel traders — who can get bank loans pledged against their steel inventory — availed themselves of the easy credit that came from the construction-led, stimulus-induced boom China enjoyed in the aftermath of the financial crisis.

But many weren’t prudent in how they acquired or used the loans, according to Bernstein. The traders – particularly those in the Shanghai and Yangtze River delta region – began to secure credit by pledging nonexistent collateral, or by pledging the same steel inventory multiple times.

In one case, Bernstein said, traders went to great lengths to disguise the fraud. “Our bank sent a group of people to Zhejiang province to investigate the problem,” one unidentified banker told Bernstein analysts, according to the report. “They went to a warehouse to check the steel inventories pledged with our bank. Much to their surprise, only the top layer of the stack was steel. Beneath the top layer was filled with nothing but sand.”

Bernstein didn’t name any banks or traders involved in the fraud in its report.

A news department official at the China Banking Regulatory Commission said the commission was monitoring the issue, but didn’t immediately offer further comment.

An official at the China Iron and Steel Association, which has jurisdiction over steel businesses, said the quasi-governmental body is aware of the allegations. Deputy secretary-general Chi Jingdong said he couldn’t ascertain if the abuses were widely prevalent but said the association believes there have been such occurrences of fraudulent loans. Mr. Chi said he wasn’t aware if the association has conducted a detailed probe yet.

In some cases, the report says, traders plowed the loans into gambles on equity markets, as steel sales alone weren’t sufficient to cover interest payments. As the stock markets slowed and steel prices fell to record lows, the traders got caught in the receding tide. Banks began to choke off credit, spurred by a directive in April from the China Banking Regulatory Commission to stamp out the steel fraud, Bernstein said.

The shakeout among steel traders is ongoing. Bernstein said its survey of steel traders along the Bohai Sea coast and Guangzhou indicated that only about half of contracted orders for steel products in September were fulfilled. “This number should be 100% in normal times and averaged 70% from July to September, according to a large steel trader in Guangzhou,” the report said.

The danger from loans made to steel traders is not spread evenly throughout China’s banking sector. For large banks, nonperforming loans made to steel traders on average amount to less than 0.5% of total loans, the report said. For smaller banks, however, exposure is 2% to 4%.

Smaller banks told Bernstein they find it difficult to call these steel manufacturers to make good on the traders’ fraud. “As a bank, you always want to please a large steel customer. How can you even sue the company?” one bank employee told Bernstein, according to the report.

Larger banks tend to hog direct relationships with the more credit-worthy larger steel producers, leaving the higher risks – steel traders – to their smaller brethren. An executive from a larger bank told Bernstein it lends only to “a very few giant steel producers.”

The Bernstein report said smaller banks have especially been in a quandary. It’s not just that they find it difficult to seize and sell repossessed steel collateral on the open market. Faced with steel traders backed in their credit guarantees by large state-owned steel producers, these smaller banks often find themselves powerless to collect the debts, Bernstein said. China’s steel industry – including its top five producers – is dominated by state-owned enterprises.

The problem is far from being resolved. Until the fraudulent debt shakes out, Bernstein says, the loan portfolios of small and medium-sized banks in China with exposure to troubled steel-trader lending will only keep deteriorating.